NEW YORK/WASHINGTON (Reuters) - The ruptured U.S. financial system was facing an unprecedented shakeup on Sunday that could lead to the failure of Lehman Brothers, the takeover of Merrill Lynch & Co Inc and big asset sales by big insurer American International Group.
The developments may indicate Wall Street and Washington are accepting that massive triage is necessary in the face of the 13-month old credit crisis and destructive U.S. housing bust.
"The U.S. financial system is finding the tectonic plates underneath its foundation are shifting like they have never shifted before," said Peter Kenny, managing director at Knight Equity Markets in Jersey City, New Jersey. "It's a new financial world on the verge of a complete reorganization."
The focus on Sunday had initially been on whether talks between regulators and Wall Street's top bankers could lead to the sale of Lehman, which until recently was the fourth-largest U.S. investment bank.
However, those talks faltered when Britain's Barclays Plc, which had appeared to be front-runner to take over Lehman -- excluding its toxic mortgage-related assets -- said it had pulled out of the bidding.
That triggered expectations the investment bank is heading into bankruptcy and prompted a rare emergency trading session on Sunday to allow Wall Street dealers in the $455 trillion derivatives market to reduce their exposure to the firm.
The Lehman news pushed U.S. stock index futures sharply lower on Sunday, with the S&P500 futures down 36.40 points at 1222.10, and the U.S. dollar tumbled in early trade in New Zealand, with the euro jumping to 1.4306/10 at 2214 GMT compared with $1.4225 in late U.S. trade on Friday.
Within hours of Barclays withdrawal, the New York Times was reporting that Bank of America was in advanced talks to acquire Merrill for at least $38.25 billion in stock, citing people briefed on the negotiations.
And then, the Wall Street Journal said that AIG, which was until recently the world's largest insurer by market value, is expected to sell off assets, including a profitable aircraft leasing arm.
Merrill, AIG and Washington Mutual, which was the subject of conflicting reports on Friday about whether it was in advanced talks for a sale to JPMorgan Chase & Co all face similar problems because of their ownership of real-estate related assets that have fallen sharply in value.
A perception among investors that the losses they have disclosed are far from enough, and that they will have difficulty in raising new capital, has driven their share prices sharply lower.
One of the catalysts for this weekend's events was the stance of U.S. Treasury Secretary Henry Paulson.
He was strongly opposed to using government money in any deal aimed at resolving the Lehman crisis, a source familiar with his thinking reiterated on Sunday.
The lack of such government guarantees was the main reason Barclays decided to exit the negotiations to buy Lehman, according to a person familiar with the matter.
An emergency trading session was set between dealers with Lehman Brothers counterparty risk involved credit, equity, rates, foreign exchange and commodity derivatives, the International Swaps and Derivatives Association said.
"This is an extremely, and I stress extremely, rare event. It also speaks to the more general notion that, in today's highly disrupted financial markets, the unthinkable is thinkable," said Mohamed El-Erian, the chief executive of Pimco, the world's biggest bond fund.
Market sources said the special session was initiated by the Federal Reserve.
The aim was to reduce risk associated with a potential bankruptcy filing by Lehman Brothers.
"Trades are contingent on a bankruptcy filing at or before 11:59 p.m. New York time Sunday (0359 GMT)," said the statement. "If there is no filing, the trades cease to exist."
The special session "is a way to offset the risk between the remaining large banks and insurance companies and fund managers prior to the markets opening in Asia," said Mark Grant, managing director of structured finance at Southwest Securities, based in Dallas.
Grant is expecting a turbulent session when the U.S. markets reopen for business on Monday.
"No one has any idea about the credit quality of the assets in Lehman's portfolio and no one has a handle about the size of the CDS (credit default swap) contracts," he said.
"The market is going to be spooked. People will be fearful and no one outside a very small group of people knows what Lehman going into liquidation will mean."
If there is a forced sale or liquidation, "this could set off another round of writedowns globally."
Lehman has been collapsing under the weight of toxic assets, mainly related to real-estate, that are now worth only a fraction of their original prices.
The crisis at Lehman presented a delicate balancing act for Paulson and the Federal Reserve, who have urged Wall Street chiefs to come up with their own solution.
So far this year, the government has sponsored rescues of Lehman rival Bear Stearns and mortgage lenders Freddie Mac and Fannie Mae.
The authorities don't want to be accused of encouraging excessive risk-taking by bailing out another yet another investment bank.
But they also cannot afford to let a blow-up of Lehman paralyze the financial system and deepen the credit crisis.
"Anyone else who has these toxic assets, if they haven't made a full confession, they better do it now," said Matt McCormick, portfolio manager at Bahl & Gaynor Investment Counsel in Cincinnati, Ohio, which has $2.9 billion of assets under management.
"These assets may be hard to unwind, but they can unwind your firm. Lehman tried to deny reality until the bitter end."
Bankruptcy would mark an ignominious end to a once-proud firm, founded by cotton-trading German immigrants 158 years ago. It would also badly tarnish the reputation of CEO Dick Fuld, who has insisted that his firm could work through its problems to survive as an independent entity.
One solution that has been considered is a hiving-off of Lehman's bad assets into a "bad bank", in which rivals would take stakes, people briefed on the matter said.
It wasn't immediately clear whether such a plan could be part of a bankruptcy filing.
Former Federal Reserve Chairman Alan Greenspan said on Sunday he suspected "we will see other major financial firms fail," but added that this did not need to be a problem.
"It depends on how it is handled and how the liquidations take place," Greenspan told the ABC program "This Week."
"And indeed we shouldn't try to protect every single institution. The ordinary course of financial change has winners and losers."
At Lehman's headquarters in midtown Manhattan, employees were coming and going throughout the day.
Few agreed to be interviewed.
"For some people it's business as usual, but other people are worried about liquidation and that they won't have jobs," commented a man who said he worked in the investment banking division.
"Some people are upstairs and working on their projects. Others are worried that they'll be out of work and are packing up," said the man, who declined to give his name.
Security outside the Fed building where talks between banks and regulators over the crisis were continuing was even tighter on Sunday than on Saturday, with nine dark-blue federal government vans blocking the area around the entrance and security guards preventing reporters from getting close. By early evening, some of the executives had left the building but others remained.
The meetings with the CEOs of Wall Street's top banks were reminiscent of the 1998 bailout of hedge fund Long-Term Capital Management, two sources familiar with the situation said.
With LTCM, major banks each contributed to a $3.65 billion bailout of the hedge fund, allowing it to be wound down in an orderly way.
This time may be different. The capital of many top banks is already strained by the credit crisis, making them reluctant to fork over funds to help Lehman, whose problems are largely a result of bad bets on the U.S. mortgage market.
Also, while LTCM was a client of most Wall Street firms, Lehman is a competitor.
Lehman has hired law firm Weil Gotshal & Manges to prepare a potential bankruptcy filing, the Wall Street Journal reported on Saturday, citing a person familiar with the matter.